Break up the too-big, too-dangerous banks

Commentary: Time to end ‘too big to fail’

WASHINGTON (MarketWatch) — There’s not much that the far left and the far right can agree on, but here’s one thing that both accept: The biggest banks are still too big and too dangerous.

Quite a few knowledgeable people in the middle also agree that the largest banks are still too big to fail, that they receive an implicit subsidy from the taxpayers, and that they remain a threat to the global economy.

It’s not yet a mainstream view, but there is a renewed recognition on the left, the right and in the center that the only way to end “too big to fail” is to simply make it impossible for banks to get too big. Keep banks small.

The largest U.S. banks — J.P. Morgan Chase
JPM, -0.62%
Bank of America
BAC, -0.84%
Citigroup
C, -0.23%
Wells Fargo
WFC, -0.68%
and Goldman Sachs
GS, -1.60%
— have gotten larger since the crisis. These five banks have assets equivalent to 55% of U.S. gross domestic product, up from 43% of GDP in 2006. They dominate the U.S. financial system, with more than 40% of bank deposits and assets.

The biggest banks in other developed countries are even more dominant in their markets, which is a big reason the euro crisis and the stagnation in Japan have festered for so long. Fixing the problem would hurt the banks, and you can’t hurt the banks without trashing the economy.

EU to curb bank bonuses

(4:24)

The European Union has moved to slap a strict limit on the bonuses of bank executives, a move likely to be replicated elsewhere as politicians move to rein in pay and cut down on risk-taking in banks.

These large institutions were at the core of the 2008 global financial meltdown, responsible for most of the losses, and all of the systemic risk. As they began to implode, they received trillions of dollars of bailouts, emergency loans and other taxpayer support to keep them alive. The bailouts were necessary, we were told, because the failure of the biggest banks would have been catastrophic.

After the bailouts, bank regulators, lawmakers and the public vowed “never again.” Authorities began to propose new rules to strengthen the banks and to make sure that, if a large bank became insolvent, there would be a quick way to kill it off without rewarding those responsible and without harming the rest of the economy.

The new rules were necessary because the failure of Lehman Bros. in September 2008 proved that the regular bankruptcy process doesn’t work for large, interconnected financial companies. Lehman’s collapse proved that the big banks are so intricately interconnected that if one catches cold, they all get deathly sick.

Lehman’s collapse set in motion a cascading wave of failure that brought the global economy to its knees in a matter of days. Yet Lehman still hasn’t emerged from bankruptcy, more than four years later.

The official answer to “too big to fail” has been to write more complex regulations to counter more complexity in financial products. The new rules codify in excruciating detail how banks should define “capital,” and “risk” and “leverage” and “proprietary trading,” and a thousand other concepts.

The idea is to force the big banks to internalize more of the societal costs of their risky behavior.

The new rules create a new bankruptcy process for large financial institutions that require shareholders to be wiped out in the event of failure. In the U.S. and in the U.K., banks are supposed to write so-called “living wills” that describe how they could be dismantled with no fuss, if necessary.

Reuters

The financial system may be no safer than it was on Sept. 15, 2008, when Lehman Brothers went bankrupt.

But there is growing skepticism that the authorities could actually wind down a global bank the size and complexity of J.P. Morgan or Barclays
BCS, -1.62%
At the Federal Deposit Insurance Corp., which has ably handled small bank failures for decades and which would be responsible for dealing with a gigantic failure in the future, top officials are steamed by a lack of seriousness by the banks in their first drafts of their living wills.

Led by FDIC Vice Chairman Thomas Hoenig, these officials are considering taking severe action against banks that don’t submit a proper living will, according to a report in the Financial Times. Banks could be forced to raise more capital or even divest themselves of their riskiest operations. Read the report in the FT.

Markets seem equally skeptical that the FDIC, the Federal Reserve or the U.K. Financial Services Authority would really wipe out shareholders and force creditors to take a haircut. The big banks enjoy a decided advantage over their smaller rivals when it comes to raising funds. According to a recent editorial at Bloomberg View, the big banks get an $83 billion annual subsidy from their status as too-big-to-fail banks. Read the editorial on the $83 billion subsidy.

Bloomberg’s back-of-the-envelope estimate is surely exaggerated (it compares the cost of obtaining funds in the bond market, but most banks get most of their funds from depositors, where the federal insurance is explicit for all banks, large and small, for amounts up to $250,000). However, researchers at the FDIC have concluded that the big banks have an advantage in attracting large deposits owing to their too-big-to-fail status, giving them an implicit subsidy of about $24 billion. Read the paper by Stefan Jackewitz and Jonathan Pogach.

The regulators who have to implement Dodd-Frank, Basel III and all the rest of the complex rules have been dealt a losing hand, and they know it.

Federal Reserve Chairman Ben Bernanke, for instance, told Massachusetts Democratic Sen. Elizabeth Warren that he agreed 100% with her statement that “the big banks are getting a terrific break and the little banks are just getting smashed on this.”

Although Bernanke thought the rules were “working to some extent,” he told Republican Sen. David Vitter of Louisiana that if the situation doesn’t improve, then “I think we ought to consider alternative and additional steps.” Vitter joined with Ohio Democratic Sen. Sherrod Brown on Thursday in supporting legislation to break up the biggest banks. Watch Vitter’s floor speech.

It may be emotionally satisfying to label the bankers as gangsters, to say they are evil. But the big banks would be a problem even if they were run by saints.

These organizations are simply too large to manage effectively, they are too complex to regulate, and they are too dangerous to ignore. It’s time to break them up.

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